An heir who inherits California real estate starts with a basis reset to the property's fair market value on the date of the decedent's death under IRC Section 1014, not the original owner's old, often much lower, basis. That fresh basis means the deferred gain and depreciation recapture the decedent had built up through prior ownership, and possibly through prior exchanges, generally does not carry forward to the heir for income tax purposes. If the heir sells shortly after inheriting at close to that stepped-up value, there may be little taxable gain at all.
Whether to sell outright or use a 1031 exchange on inherited property is a separate question from the basis reset itself. An heir who wants to keep the real estate investment going, perhaps trading a management-intensive property for something more passive, can still use a 1031 exchange starting from the stepped-up basis; the step-up and the exchange are not mutually exclusive. What matters is holding the inherited property for investment or business use, and having enough of a documented holding period and intent, before treating a sale as eligible for exchange treatment.
California adds its own layer for heirs selling: withholding under California Form 593 generally applies at closing regardless of whether the seller owes tax, and it is reconciled against the actual tax liability when the return is filed.
The starting point is a qualified appraisal or other reliable valuation as of the date of death, or the alternate valuation date if the estate elected one. IRS Publication 551 explains how basis is determined for inherited property. That appraised value becomes the heir's basis for calculating gain or loss on any future sale, and it also becomes the new basis for calculating depreciation if the heir keeps the property as a rental or business asset.
Documentation matters here more than most heirs expect. An estate that did not commission a formal appraisal near the date of death can leave the heir with a weaker basis argument later, particularly if the IRS or the California FTB questions the value used. Getting a contemporaneous appraisal, or confirming the estate's valuation records, before any sale or exchange is the first practical step.
If the heir continues renting the inherited property, depreciation begins again from the new stepped-up basis over the applicable recovery period for the property type, as though the heir had just purchased the property at that value. The decedent's depreciation schedule, and any recapture that had built up under the prior owner, does not transfer to the heir.
This creates a meaningfully larger depreciable basis than the decedent had in the final years of ownership, which can mean substantially larger depreciation deductions for the heir going forward, an important factor when deciding whether to keep the property as a rental, sell it, or exchange it into something else.
Section 1031 requires that both the relinquished and replacement property be held for investment or for use in a trade or business, not for personal use or primarily for resale. An heir who inherits a property and wants to exchange it relatively soon afterward needs to be able to show the property was actually held for investment purposes during that interim period, such as by renting it out, rather than simply holding vacant family real estate awaiting a decision.
There is no fixed statutory holding period that guarantees investment intent, and the IRS looks at facts and circumstances. An heir who moves into the inherited property as a personal residence, or who lists it for sale within weeks with no rental activity, has a harder case for exchange treatment than one who rents it out for a meaningful period and can document that intent with lease agreements and reported rental income.
When California real estate is sold, the buyer or escrow is generally required to withhold a percentage of the sale price under California's real estate withholding rules and remit it to the FTB, unless a specific exemption applies, such as certain exchanges structured to qualify. Heirs selling inherited property outright, without an exchange, should expect Form 593 withholding to apply at closing even though their stepped-up basis may mean little or no actual gain is owed.
The withheld amount is not the final tax bill; it is reconciled against the actual liability when the heir files a California return for that year, and any excess withheld is refunded. Heirs who expect little or no gain because of the step-up should still budget for the withholding hit at closing and plan for the refund timeline separately.
An heir with siblings or co-owners often faces a decision that is more about family logistics than tax mechanics: sell and split proceeds, keep the property and rent it out jointly, or have one heir exchange their share while others cash out. A 1031 exchange generally requires each exchanging party to hold their own qualifying interest, which means co-owned inherited property sometimes needs to be structured or divided carefully before an exchange, often through a tenants-in-common arrangement, to let one heir defer gain while another takes cash.
Heirs who want investment real estate exposure without taking on landlord duties on an inherited property sometimes look at a Delaware statutory trust interest as a replacement option in a later exchange, since it allows a smaller, passive equity stake rather than sole responsibility for a single asset. That path should be weighed against the specific offering's terms, not assumed to fit every heir's situation.
